By Gertrude Chavez-Dreyfuss and Joice Alves

NEW YORK/LONDON (Reuters) -The dollar slid to more than a one-week low on Wednesday as data showed a drop in U.S. private sector employment in January due to the increase in COVID-19 infections, easing expectations the Federal Reserve would announce a large interest rate increase at its policy meeting in March.

In contrast, the euro gained for a third consecutive day, coming off a 20-month low last week, as euro zone inflation rose to a new record high last month. That fuelled bets the European Central Bank could raise interest rates sooner than expected.

The dollar index, with the euro as the largest component, fell 0.3% to 95.9280. It is on track for its largest weekly percentage loss since November 2020, at 1.3%.

ADP reported on Wednesday that U.S. private payrolls dropped by 301,000 jobs last month. Data for December was revised lower to show 776,000 jobs added instead of the initially reported 807,000. Economists polled by Reuters had forecast an increase of 207,000 in private payrolls.

“At the margin, the ADP reinforces the less hawkish rhetoric from the Fed,” said Vassili Serebriakov, an FX strategist at UBS in New York.

“U.S. payrolls are going to be weak this Friday, but the market is already prepared for that. I think it won’t be a big change for the Fed because of the inflation focus,” he added.

After the release of the ADP data, U.S. rate futures priced in about 4.6 hikes this year, or about 116 basis points of policy tightening, down from the five rate increases that were seen over the last two days. Futures also showed the probability of a 50-basis-point hike in March dropped to 6.5%, from as high as 32% late last week.

Fed officials this week also backtracked on some of the central bank’s hawkish comments, helping push the dollar lower.

Although they said the Fed would raise interest rates next month, these officials have all but ruled out a 50-basis-point increase in the central bank’s benchmark overnight interest rate at the March 15-16 meeting and will keep their options open after that.

Even St. Louis Fed President James Bullard, a voter this year on the policy-setting Federal Open Market Committee and one of the more hawkish Fed officials, also pushed back against a larger rate hike in March, noting that markets have on their own started to push up borrowing costs already.

In the euro zone, markets are expecting the ECB to turn hawkish after an annualized inflation number of 5.1% in January, up more than twice the ECB’s 2% target.

The euro firmed 0.3% to $1.1307, after earlier touching more than a one-week high, on growing expectations the ECB might signal a faster path for policy tightening at its meeting on Thursday.

Ulrich Leuchtmann, head of foreign exchange at Commerzbank, said money markets have now priced in an ECB rate increase for the last quarter of the year.

In the short term, the impact on the euro will depend on what ECB President Christine Lagarde has to say on Thursday, he said.

Shaun Osborne, chief FX strategist at Scotiabank in Toronto, said the ECB is in an “uncomfortable position,” but he expects it to remain committed to no hikes this year, “which will remain a drag on the euro.”

Sterling rose 0.2% to $1.3556, after earlier hitting a nearly two-week peak against the dollar at $1.3586 ahead of a Bank of England policy meeting on Thursday.

Investors have fully priced in an expected increase in the BoE base rate by 25 basis points to 0.5% on Thursday.

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Currency bid prices at 10:20AM (1520 GMT)

Description RIC Last U.S. Close Pct Change YTD Pct High Bid Low Bid

Previous Change

Session

Dollar index 96.0510 96.2660 -0.21% 0.406% +96.3030 +95.7930

Euro/Dollar $1.1295 $1.1274 +0.20% -0.64% +$1.1330 +$1.1267

Dollar/Yen 114.3050 114.6850 -0.33% -0.70% +114.8000 +114.1550

Euro/Yen 129.09 129.26 -0.13% -0.94% +129.4700 +129.0500

Dollar/Swiss 0.9195 0.9209 -0.15% +0.81% +0.9222 +0.9178

Sterling/Dollar $1.3560 $1.3526 +0.26% +0.27% +$1.3586 +$1.3522

Dollar/Canadian 1.2699 1.2681 +0.20% +0.49% +1.2705 +1.2650

Aussie/Dollar $0.7123 $0.7129 -0.08% -2.00% +$0.7158 +$0.7121

Euro/Swiss 1.0384 1.0377 +0.07% +0.14% +1.0408 +1.0378

Euro/Sterling 0.8327 0.8334 -0.08% -0.87% +0.8351 +0.8330

NZ $0.6632 $0.6639 -0.13% -3.13% +$0.6662 +$0.6630

Dollar/Dollar

Dollar/Norway 8.8110 8.8365 -0.40% -0.09% +8.8360 +8.7565

Euro/Norway 9.9543 9.9510 +0.03% -0.59% +9.9730 +9.9159

Dollar/Sweden 9.2152 9.2575 -0.26% +2.19% +9.2673 +9.1696

Euro/Sweden 10.4088 10.4362 -0.26% +1.71% +10.4426 +10.3916

(Reporting by Gertrude Chavez-Dreyfuss in New York and Joice Alves in London; Editing by David Goodman, Frank Jack Daniel, Chizu Nomiyama and Paul Simao)